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Per Stirling Capital Outlook – February

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The concept of “American exceptionalism” was first introduced by Alexis de Tocqueville in 1831.  It promoted the idea that the United States was not only quantitatively different, but also superior to other countries, as a result of its unique historical evolution and its national credo.  For example, America (which boasts the world’s largest military) could virtually always be counted on to fight on the side of “right”.  Even staunch skeptics like Winston Churchill agreed that “You can always count on the Americans to do the right thing, after they have tried everything else”.

Regardless of whether or not one buys into the concept of “American exceptionalism” from a societal, moral or cultural perspective, there is no doubt that, particularly since World War II, “American exceptionalism” has been very evident from an economic and financial perspective.

After all, the U.S. dollar is the world’s reserve currency, the U.S. stock market represents almost 56% of the world’s total combined stock market capitalization, and the U.S. economy is still the largest economy in the world (based upon International Monetary Fund data, see below).  Further, when global fear levels are running high, money from all over the world has historically tended to seek refuge in the U.S. dollar and U.S. dollar-based assets.

Remarkably, until very recently, the United States was actually one of the few industrialized economies that managed to avoid resorting to negative interest rates to survive the pandemic.  Instead, the U.S., unlike Europe and Japan, augmented its massive monetary stimulus programs with similarly massive fiscal stimulus programs.

In total, there have been five U.S. fiscal stimulus packages totaling more than $5 trillion, in addition to $4.5 trillion of monetary stimulus, over just the past 1.5 years.  To put this into some perspective, current estimates for the size of the U.S. economy are less than $25 trillion ($24.79 trillion for 2022).  This means that the stimulus totaled over 38% of the size of the entire U.S. economy.

This historic level of stimulus produced stellar economic and earnings growth in the U.S., and helped to get the world economy back on its feet from the pandemic-related decline.  It also left the United States with an inflation rate that is sufficient to double the cost of living every nine years (the worst in forty years), and a resulting need to pursue very aggressive monetary tightening, which is very likely to further slow an already significantly slowing domestic economy.

Even if you just consider core inflation, which excludes the volatile food and energy components, you can see that the U.S. has a much greater inflation problem than do most major foreign economies, and that suggests that the U.S. will face much stronger monetary policy headwinds than will most of its foreign counterparts.  Such strong headwinds should have a dampening effect on both the U.S. economy and the domestic financial markets, some of which is already evidencing itself.

In addition, the U.S. has, to a certain extent, been a victim of its own success (i.e., exceptionalism) as, for the past quarter century, returns in the domestic stock market have so dramatically outpaced those of its foreign counterparts that U.S. shares are now very overvalued, particularly on a relative basis. Indeed, U.S. stocks are now selling at almost twice as much per dollar of expected earnings as do stocks in the emerging markets and the United Kingdom, and approximately 50% more than they are selling for in Western Europe and Japan.

This combination of lower inflation and less expensive valuations may prove to be a significant advantage for foreign stocks over the near and intermediate term.  By contrast, in the U.S., we expect for very high levels of inflation to further exacerbate high valuations by further depressing corporate profitability.  For example, over the past 12 months, U.S. producer inflation has exceeded U.S. consumer inflation by a whopping 2%, which suggests that companies are having difficulty passing on their higher costs to the final consumer, which squeezes profit margins.

A simple comparison of U.S. valuations versus those of all global equities excluding the U.S. shows that, when valued based upon the profits that they produce, U.S. stocks are, on average, 53% more expensive than their foreign counterparts.  Put another way, it would take 20.8 years-worth of the average U.S. stock’s earnings to equal the price paid for the average U.S. stock.  In contrast, it would take only 13.6 years-worth of average foreign earnings to buy the average foreign stock.

We would like to emphasize that valuation measures like these have traditionally served very poorly as a short-term timing tool.  That said, valuations can usually tell you much about potential risk and potential return from a more intermediate-term perspective.  For example, while the past is not necessarily prologue, the lesson from past history is that, when the U.S. equity markets have previously been as highly valued as they are today, the average annual return for the next five years has been right around 0% per year.

Importantly, we believe that there will still be plenty of opportunities to make money in U.S. stocks.  We just expect for the current macroeconomic and monetary policy environments to exacerbate the current decline in risk appetite and, as a result, continue the shift in market leadership away from technology stocks and the highly-priced, innovation-driven stocks that have powered the domestic stock market over much of recent decades, and into stocks of value-oriented and/or dividend paying companies with strong balance sheets, predictable earnings, and high levels of free cash flow.

Indeed, one of the things that makes the U.S. stock market so unique, and which accounts for much of its recent outperformance versus its foreign peers, is that it is so dominated by growth stocks in general, and technology stocks in particular.  Among the 1,000 largest publicly-traded companies in the United States, the market capitalization of growth stocks is almost five times as large as that of these more value-oriented stocks that we expect to outperform.  This is in sharp contrast to most foreign markets, where technology-oriented stocks play a much less influential role.  For example, whereas technology and telecommunications stocks represent 39.33% of the S&P 500 Index, they only represent 18.44% of the world (ex-U.S.) stock market capitalization.

Indeed, in the foreign markets, the financial sector, which actually tends to benefit from higher interest rates, accounts for over one-fifth of total market capitalization, and industrial and consumer discretionary stocks are as influential in the indices as are technology stocks.

This provides a great segue to another important point, which is that, while the domestic markets have dramatically outperformed the foreign markets for most of the past 15 years, such an extended period of outperformance is a historical anomaly, as foreign and domestic stocks have historically rotated in and out of market leadership in two-to-seven-year cycles.

So, what could explain the dramatic and sustained outperformance of domestic stocks over the past almost 15 years?  We believe that the answer is found in this chart of the World Technology Index divided by the Global stock market, which shows that technology stocks (the largest and most important of which are listed on U.S. exchanges) have outpaced the global equity markets as a whole by 123% between the start of 2008 and the end of 2021.

In other words, we believe that the U.S. markets have outperformed their foreign peers primarily because of dramatic outperformance by the technology sector overall, and the fact that U.S. markets are disproportionately influenced by technology stocks.

However, if we are correct that a change in sector leadership is underway in the U.S. from high-priced growth and technology stocks to high quality and value-oriented stocks, that very same transition should, in our opinion, also start to favor the performance of many foreign stocks over their American counterparts, because foreign markets are less technology stock dependent.  Indeed, if you look at the above chart, which divides the value of the 2,700 largest U.S. stocks by the value of the global markets (excluding the U.S. component), you will see that foreign stocks have already been significantly outperforming domestic stocks since the start of the year.

While we do believe that there is an increasingly compelling set of economic and valuation-related reasons to increase one’s exposure to foreign stocks, there are two significant non-economic reasons why investors should consider either temporarily deferring those foreign purchases, or at least establishing them in stages.

The first has to do with the state of the pandemic.  Whereas the United States is enjoying a dramatic decline in both new COVID case counts and deaths, the rest of the world is nowhere near as fortunate.  Indeed, Europe is approaching its highest case counts of the entire pandemic, and countries in Asia are setting new records for new COVID case counts on an almost daily basis.

Moreover, as was recently noted by the United Nations, 75% of all vaccines administered in the world thus far have taken place in just 10 countries, while 130 other countries have not yet administered a single shot, which means that the pandemic remains an ongoing concern in much of the world.  While we do expect for science to ultimately overwhelm the virus on a global basis, the world is not out of the woods quite yet.

A more tactical reason to at least temporarily postpone boosting foreign equity allocations is obviously the current conflict between Russia and Ukraine, which is escalating quite rapidly as we write this report.

Mark Twain famously noted that “history does not repeat itself, but it oftentimes rhymes”.  If it “rhymes” again this time, then precedent suggests that this conflict may create an excellent and very timely opportunity to add to foreign equity allocations.

Indeed, the lesson of history is that stock market declines related to such geopolitical conflicts tend to be rather short-lived.  For example, when Russia invaded Crimea in early 2014, and basically annexed the territory from the Ukraine, the U.S. stock market declined by almost 8%, but then not only recovered, but also set new all-time highs only twenty days later.

Of course, this time it appears that Putin has even grander ambitions, and the fact that most of the energy pipelines that carry energy from Russia to Western Europe run through the Ukraine suggests that there could be much greater economic implications of an invasion of the Ukraine as a whole than we saw with Crimea, including the facts that Putin may “weaponize” its energy resources to punish Western Europe and that economic sanctions imposed against Russia could potentially have very broad global economic implications.

That said, a study by Ned Davis Research examined the 28 worst political or economic crises in the six decades before the 9/11 attacks of 2001. In 19 of those cases, the Dow was higher six months after the crisis began and the average gain 6 months after all 28 crises was 2.3%.

Moreover, Truist just released a report showing that “in nine of the last 12 geopolitical shock events, the S&P 500 Index was higher 12 months later, with an average 12-month return of 8.6%.”

Indeed, according to that Truist report, “the three highlighted instances in the graph (above), where stocks were down a year later, coincided with recessions”, and “that the history of these types of events tend to have a fleeting market impact unless they lead to a recession.”

Of course, when you throw a major geopolitical crisis on top of a rapidly slowing economy and a global shift towards aggressively restrictive monetary policies, one certainly cannot rule out recession as a possibility.

In summary, since the pandemic-driven market lows of 2020, investors have benefitted from a set of economic and monetary conditions that were virtually ideal for a “risk-on” market (growth stocks and highly-valued stocks in general, and innovative, technology-oriented stocks in particular).  However, many of those conditions are currently being turned on their heads, and we believe that it is only logical that elements of market leadership are also likely to reverse, and that many of the underperformers of recent years, including high-quality stocks, value stocks, cyclical stocks and foreign stocks, may well assume the mantle of leadership in this new environment.

Advisory services offered through Per Stirling Capital Management, LLC. Brokerage services and securities offered through B. B. Graham & Co. Inc., member of FINRA/SIPC. Per Stirling Capital Management and B. B. Graham & Co. Inc. are separate and otherwise unrelated companies.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Nothing contained herein is to be considered a solicitation, research material, an investment recommendation or advice of any kind. The information contained herein may contain information that is subject to change without notice.  Any investments or strategies referenced herein do not take into account the investment objectives, financial situation or particular needs of any specific person. Product suitability must be independently determined for each individual investor.
This document may contain forward-looking statements based on Per Stirling Capital Management’s expectations and projections about the methods by which it expects to invest.  Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions.  In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements.  Such statements are not guarantying future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict.  Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of Per Stirling Capital Management’s independent advisors.
Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market.  They are methods used to help manage investment risk.
The Standard & Poor’s 500 (S&P 500) is a market-capitalization-weighted index of the 500 largest publicly-traded companies in the U.S with each stock’s weight in the index proportionate to its market. It is not an exact list of the top 500 U.S. companies by market capitalization because there are other criteria to be included in the index.
Real gross domestic product (GDP) is a comprehensive measure of U.S. economic activity. GDP measures the value of the final goods and services produced in the United States (without double counting the intermediate goods and services used up to produce them). Changes in GDP are the most popular indicator of the nation’s overall economic health.
Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks, primarily industrials including stocks that trade on the New York Stock Exchange. The Dow, as it is called, is a barometer of how shares of the largest US companies are performing.
MSCI World Information Technology Index is designed to capture the large and mid-cap segments across 23 Developed Markets (DM) countries*. All securities in the index are classified in the Information Technology sector as per the Global Industry Classification Standard (GICS®).
Past performance is no guarantee of future results.  The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted.